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A Tough Road for Wal-Mart Shareholders

By Peter J. Henning May 7, 2012 3:58 pmMay 7, 2012 3:58 pm

Wal-Mart shareholders are understandably upset with the company. The retailer’s shares have taken a pounding after The New York Times reported on a bribery scandal at the company’s Mexican subsidiary that some executives are said to have known about but chose to ignore. In the days after the disclosure, Wal-Mart’s shares lost nearly 8 percent of their value, totaling more than $15 billion.

In reaction to the news, the California State Teachers’ Retirement System, known as Calstrs, filed a complaint in Delaware last week accusing directors and officers of breaching their fiduciary duties. It asks for damages and changes to Wal-Mart’s corporate governance.

Unfortunately for shareholders, it is unlikely that the complaint will result in any significant changes at Wal-Mart. It is difficult to survive the motion to dismiss that the defendants can be expected to file, and then proving a violation under Delaware law is nearly impossible if the case moves forward.

The lawsuit that Calstrs filed is known as a shareholder derivative action, which means the company is the plaintiff because it was harmed by the actions. This is a device that gives the owners of a company – the shareholders – a means to police the conduct of corporate directors and management, who would probably be unwilling to sue themselves on behalf of the company.

Derivative suits are a bit of an odd duck in the corporate world because a company’s board is responsible for deciding how the corporation should act, including whether to pursue a lawsuit. But the law recognizes that the board may have an inherent conflict of interest if the harm were caused by corporate officials.

Therefore, the law allows shareholders to file a claim on a company’s behalf. Any money recovered goes to the corporation rather than the individual shareholders because the violation only harmed the organization.

Under state law and the charters of virtually every public company, the corporation has an obligation to advance the legal fees for directors and officers sued for their conduct, so the company bears much of the cost of a derivative lawsuit. And not every legal claim is worth pursuing, even if it has merit, especially when the company has to pay for all the lawyers.

To protect against baseless claims or lawsuits that will result in little real benefit to the company, the law requires that shareholders, before filing a claim, must ask the board to decide whether to proceed with the case. This requirement is excused if a majority of the board has a conflict of interest. But even if such conflicts exist, Delaware law still requires the plaintiffs to explain why they believe they can bypass the board. The first issue in most derivative suits is a motion to dismiss the case because there was no demand on the board.

Calstrs asserts that a majority of Wal-Mart’s 15-member board are not “disinterested and independent,” the legal standard for a director to act on a demand. The complaint states that 11 directors “affirmatively refused to investigate the corruption” at the subsidiary or lack the independence to judge the matter.

Simply naming directors as defendants and asserting they should have done a better job does not usually establish that they cannot make a decision on the validity of a derivative claim. Delaware courts require more concrete evidence of a connection between the directors and the violation before allowing a case to proceed.

The likelihood of a board pursuing a case against other directors is negligible if demand is required, so if the Delaware court rejects Calstrs’ argument, it would probably terminate the derivative lawsuit. Even if shareholders can surmount this procedural hurdle, proving that the directors and officers breached their fiduciary duties is difficult because Delaware courts have set a high standard for establishing a violation.

The Calstrs suit contends that the directors failed to adequately monitor the conduct of employees to ensure that foreign bribery did not occur, and that reports of violations were not promptly investigated. This test is called the Caremark duty, named after a decision in 1996 by then-Chancellor William T. Allen in the case In re Caremark International Inc. Derivative Litigation.

In that case, Chancellor Allen held that “a director’s obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may, in theory at least, render a director liable for losses caused by noncompliance with applicable legal standards.”

Although a number of Caremark-type claims have been filed by shareholders, decisions finding an actual violation are almost nonexistent. Most companies now have in place fairly extensive compliance programs, including Wal-Mart. As The New York Times reported, the problem was not that the Mexican bribery went unnoticed, but that when officials were informed of it, they appeared to have blocked any further investigation.

How Wal-Mart handled the internal inquiry is different from the Caremark duty of the directors, which only requires a system be in place that is adequate to deal with potential violations. The fact that the system may have broken down does not mean the directors violated their fiduciary duty.

In filing the shareholder derivative complaint, the Calstrs chief executive, Jack Ehnes, stated that one goal was to seek “corporate governance reform to ensure that similar misconduct is not repeated in the future. We need truly independent directors who will set the right tone from the top.”

Even if the case is successful, the likelihood that there will be any major change in Wal-Mart’s governance is low. The family of Wal-Mart’s founder, Sam Walton, controls just under 50 percent of the shares, so its members effectively decide who is on the board, and the group ultimately responsible for how the company is operated.

The best hope for changes at Wal-Mart may be the Justice Department and the Securities and Exchange Commission, which are investigating potential violations of the Foreign Corrupt Practices Act by the company.

In resolving cases like this, the government could enter into a deferred agreement or a nonprosecution agreement that forces the company to further strengthen its compliance program. Such steps could include requiring greater oversight by independent directors and the outside auditors to ensure that a report of bribery is not whisked away again. It is possible the government would even require the appointment of an outside monitor to ensure Wal-Mart puts in place any changes called for by an agreement.

When a company resolves a government investigation, it often also settles outstanding shareholder litigation to put the entire affair behind it. If the Calstrs complaint can survive an initial motion to dismiss, it will probably piggyback on what the Justice Department and S.E.C. obtain, plus perhaps a small payment (probably covered by insurance) to the company’s coffers.

Just don’t expect that shareholders will recover even a fraction of the $15 billion in lost stock value that occurred after the news of the bribery scandal broke.